Sunday, June 29, 2014

James Turk Responds to the LBMA

Over the past two weeks the LBMA has been conducting a survey of market participants that trade physical silver. They are taking this step in response to the decision to end the daily silver fix.

The LBMA said: “In view of the recent announcement by the London Silver Market Fixing Ltd., it is important to gather the views of the global market to find a solution that meets the needs of market users around the world. The launch of the survey is an integral part of this process.

The LBMA reported that more than 250 people responded to its survey, which ended Friday. Here is my response to the key questions the LBMA posed....

“1. Is the current silver price discovery method sufficient?

The market for silver derivatives dominates price discovery for physical silver, which explains why gold and silver have been in backwardation more often than not since July 2013. This backwardation is proof positive of the abnormal influence of silver derivatives on the pricing structure, as is the fact that commitments to deliver silver in the aggregate far exceed the annual new supply; they even exceed available above-ground supplies. In this regard, an analysis of U.S. Commodity Futures Trading Commission data shows that futures derivatives of commodities such as corn or soybeans do not exceed annual supply. Backwardation in gold in theory is impossible because it would mean participants are passing up the free arbitrage. Given that silver is a gold substitute in that at present 66 ounces of silver provide the same safe-haven characteristics as one ounce of gold (that is, money outside the banking system), backwardation in silver is impossible too, yet backwardation has prevailed on and off for months. That the LBMA 18 months ago stopped reporting SIFO shows how artificial the price curve is for silver. Back then the LBMA stated in effect that customers were unable to transact at the SIFO rate being quoted, which meant that paper pricing was unrealistic because sellers of paper were unable to commit to physical delivery at the prices being posted (that is, posted but not true dealing quotes). If silver derivatives did not dominate the pricing structure, the price of physical silver would be much higher. A similar situation prevails in gold, but is not as extreme (that is, prices in gold are not as unrealistically low as they are in silver).

2. What new improvements would you like to see/recommend?

There are two very different silver markets. One is for physical silver, which is a tangible asset of limited availability. The other one is for paper silver, which includes derivatives of all sorts that can be issued in essentially unlimited supply, meaning that it is impossible for ALL sellers of these derivatives to meet their commitments to deliver physical silver if called on to do so. The paper silver market is in effect a fractional reserve system, which obviously could result in adverse systemic consequences for banks and other participants should a silver squeeze occur (as it did in September 1979 to January 1980). These two silver markets need to be clearly delineated for the benefit of market participants, and the short side of the paper silver market needs to be controlled with rigid governors to impose discipline on the quantity of paper issued. If the prices of silver along the curve (that is, spot or forward) in these two different markets are to intersect as they do now, the shorts in the paper market need to prove that they can deliver physical metal. Doing so would improve the accuracy of any price discovery in the silver market by making spot and forward prices more realistic because they would become an authentic reflection of true supply conditions. Namely, there would be an acknowledgement that the supply of physical silver is limited. Thus, silver price discovery would be improved by imposing discipline that would prevent the paper shorts from dominating the price of physical silver.

3. What are the essential features that you would wish to see in any replacement?

Derivative contracts can settle in either cash or metal. Both the buyer and the seller need to put up margin as evidence of their ability to fulfill the terms of the contact they enter into. These margin requirements are now met generally by providing cash. Though margins can also be met with physical metal in some cases, it is rare. My proposal would be for cash settlement contracts to be margined with cash, regardless whether the participant is long or short the contract, and can be essentially unlimited in terms of the number of contracts issued. In contrast, derivatives that commit to deliver physical metal should be margined differently, in effect controlling the shorts which in turn also would result in disciplined control of the longs of these contracts. Those who have bought a contract that could result in the delivery of physical silver should meet their margin requirement with cash. But those who have sold short a contract that could result in the delivery of physical silver should meet their margin requirement by having physical metal stored in an LBMA-approved vault. As is now the case, the size of the margin requirement can be periodically set by an exchange for exchange-traded derivatives or a regulatory body such as the Bank of England for over-the-counter trade derivatives. Note that even though the short sellers of contracts that could result in the physical delivery of metal are meeting their margin requirement with physical metal, the fractional-reserve nature of the physical market will not disappear. For example, if a 50-percent margin requirement was imposed, the commitments to deliver physical metal in the aggregate could grow to twice the available stock, unless of course the short sellers have additional physical metal available that is not being put into LBMA vaults for margin. But the objective of requiring these short sellers to meet margin requirements with physical metal is not to try eliminating the fractional-reserve aspect of the market, which is probably an impossible task given the human tendency to expand credit. Rather it is simply a method of imposing prudent discipline on the silver market by controlling short sellers of silver derivatives.

4. Which market participants would be the ideal contributors to the pricing mechanism? (for example, bullion banks, manufacturers, refiners, others?).

All market participants should be the contributors to the pricing mechanism. When a trade takes place on an exchange or over the counter, the data of that trade should be immediately provided to neutral third parties to collect and report (for example, Bloomberg, Reuters, et al.). Aggregate data should also be reported. For example, this would include measurements of the total outstanding commitments for physical metal by size and forward date.

5. Other comments on the pricing mechanism?

While I have focused almost exclusively on silver, my analysis and recommendations also apply to gold."